The Fire Fueling Gold

Gold took quite a beating in September, bucking its seasonal average monthly
return of 2.3 percent. The political battle between President Barack Obama
and Congress, China's Golden Week, and India's gold import restrictions likely
weighed on the metal.

September's correction only adds to the negative sentiment toward the precious
metal. The assumption from many market pundits is that gold is no longer attractive
as an investment. With rising rates and continuing low inflation, U.S. investors
believe they have a solid case for selling their holdings.

However, this could be a premature assessment, causing these bears to potentially
lose out on a lucrative position.

Allow me to use an ice cube to explain.

One of the strongest drivers of the Fear
Trade is real interest rates. Whenever a country has negative-to-low
real rates of return, which means the inflationary rate (CPI) is greater
than the current interest rate, gold tends to rise in that country's currency.

Our model tells us that the tipping point for gold is when real interest
rates go above the 2-percent mark.

Consider the ice cube, which shows how new equilibriums can have significant
effects. At 31 degrees, H2O is a solid chunk, but when the temperature increases,
the mass slowly begins to turn into a liquid. Above 32 degrees, ice changes
form from solid to liquid, but it's still made of hydrogen and oxygen.

Because money is like water, when many other economic dynamics, such as population
growth, urbanization rates and changes in government policies, reach their
tipping point, the velocity of money tends to be altered.

As global investors, we watch for changes in these trends to know how to invest
in commodities and markets, find new opportunities and adjust for risk.

So, how close to gold's tipping point are we? In other words, what is the
real interest rate today? As you can see below, Treasury investors continue
to lose money, as the 5-year bill yields 1.41 percent and inflation sits at
1.5 percent. This is nowhere near the 2 percent mark.

I would be worried about gold if real interest rates solidly crossed the 2
percent threshold for an extended amount of time, because it would have a dramatic
effect on gold as an asset class. In a high interest rate environment, gold
and silver lose their attraction as a store of value.

In order for that tipping point to happen, rates would need to continue rising
above inflation, and inflation would need to remain low. These are the forecasts
made by many gold sellers today; however I wouldn't get too trigger happy just
yet, as recent data challenges these assumptions.

Take the monthly unemployment figure, which is one of the primary indicators
the Federal Reserve studies when evaluating the economy. But depending
on the definition of an unemployed person, the numbers reveal different results.

The official U3 unemployment rate, the exact figure Ben Bernanke uses, tracks
the total unemployed as a percent of the civilian labor force.

The broadest gauge calculated by the Bureau of Labor Statistics (BLS) is the
U6 unemployment rate. For this number, the BLS adds in all those people who
are marginally attached to the labor force, plus people working part-time but
want to work full-time.

What does "marginally attached to the labor force" mean? These people are
neither working nor looking for work but indicate they want a job, are available
to work and have worked during some period in the last 12 months. These marginally
attached people also include discouraged workers who are not looking for work
because of some job-market related reason.

Then there's a measure of the labor market the BLS tracked prior to 1994.
This is the seasonally-adjusted alternate unemployment rate that statistician John
Williams continued to calculate. It's basically the U6 plus long-term discouraged
workers.

While the figures closely followed one another from 1994 through 2009, there's
recently been a shift. U3 and U6 have been trending downward over the past
few years, whereas Williams' ShadowStats unemployment rate shows a noticeably
upward trajectory. Perhaps the official unemployment figure overstates the
health of the economy?

Then there's the suggestion of inflation manipulation. Even though
the U.S. has been reporting a low inflation number, things feel more expensive
to many Americans. Disposable income has been growing less than inflation in
recent years; perhaps that's why many people feel "squeezed."

Also consider Williams' chart below. It shows monthly inflation data going
back for more than a century. The blue and grey shaded areas represent BLS'
historical Consumer Price Index (CPI). You can clearly see the wild swings
of inflation and deflation, especially during World War I, the Great Depression,
and World War II, as well as the stagflation of the 1970s and early 1980s.

However, shortly after disco, bell bottoms, and episodes of "All in the Family" faded
from memory, the U.S. adjusted CPI, not once but twice, first in the early
1980s and again in the mid-1990s. If you use the pre-1982 calculation, you
end up with a much different inflation picture. This is the area shaded in
red.

Figures don't lie, but liars figure

Way back in 1889, statistician Carroll D. Wright, in addressing the Convention
of Commissioners of Bureaus of Statistics of Labor, talked about the impartial
and fearless presentation of its data, using the above play on words. He said,

"The old saying is that 'figures will not lie,' but a new saying is 'liars
will figure.' It is our duty, as practical statisticians, to prevent the liar
from figuring; in other words, to prevent him from perverting the truth, in
the interest of some theory he wishes to establish."

Wright's speech seems particularly relevant today.

For patient, long-term investors looking for a great portfolio diversifier,
a moderate weighting in gold and gold stocks may be just the answer. And, today,
when looking across the gold mining industry, you'll find plenty of companies
that have paid attractive dividends, many higher than the 5-year government
yield.

Check out a discussion of some of these gold miners in my recent
blog post about the Denver Gold Forum.

Make sure you don't miss the next blog post. Give us your email
address and we'll let you know the next time we update the blog.

Frank Holmes is CEO and chief investment officer of U.S. Global Investors,
Inc., which manages a diversified family of mutual funds and hedge funds specializing
in natural resources, emerging markets and infrastructure.

The company's funds have earned more than two dozen Lipper Fund Awards and
certificates since 2000. The Global Resources Fund (PSPFX) was Lipper's top-performing
global natural resources fund in 2010. In 2009, the World Precious Minerals
Fund (UNWPX) was Lipper's top-performing gold fund, the second time in four
years for that achievement. In addition, both funds received 2007 and 2008
Lipper Fund Awards as the best overall funds in their respective categories.

Mr. Holmes was 2006 mining fund manager of the year for Mining Journal, a
leading publication for the global resources industry, and he is co-author
of "The Goldwatcher: Demystifying Gold Investing."

He is also an advisor to the International Crisis Group, which works to resolve
global conflict, and the William J. Clinton Foundation on sustainable development
in nations with resource-based economies.

Mr. Holmes is a much-sought-after conference speaker and a regular commentator
on financial television. He has been profiled by Fortune, Barron's, The Financial
Times and other publications.

Please consider carefully a fund's investment objectives, risks, charges and
expenses. For this and other important information, obtain a fund prospectus
by visiting www.usfunds.com or by calling
1-800-US-FUNDS (1-800-873-8637). Read it carefully before investing. Distributed
by U.S. Global Brokerage, Inc.